May 5, 2013

Interest Rates, Entrepreneurs, and the Federal Reserve

QE4: (Quantitative Easing, Round 4) The Federal Reserve's policy to 'print' $85 billion every month in order to "stabilize the economy"

M2: The money supply* (in essence) that the Fed is increasing with QE

Inflation: An increase in the money supply

On October 27, 1978, the Federal Reserve Act was amended to include section 2A:

"The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." [emphasis added]

How does one "effectively promote" "maximum employment, stable prices, and moderate long-term interest rates"?

It seems as though Ben Bernanke et al look at history and see that when our economy is healthy, employment is high, interest rates are "moderate", and prices are stable. Upon observing this phenomenon, they seem inclined to believe that the healthy economy is a result of these key indicators, and therefore, believe that by forcing these indicators to be at levels which coincide with economic health throughout history, the economy will be returned to good health once again.

Austrian economists, on the other hand, view these indicators as the result, and not the cause of, economic health. By assuming this viewpoint, Austrians are forced to look deeper into the issue and again ask, "How does one "effectively promote" maximum employment, stable prices, and moderate long-term interest rates"? Their answers are often found to be in contrast to the solutions proposed by the dominant Keynesian viewpoint.

In regards to the interest rate, Austrians defend its role as an economic indicator, which operates to coordinate the activities of the entrepreneur with the intentions and desires of consumers. Basic supply and demand analysis will show that as more money is deposited into savings accounts, the incentive to save becomes diminished (the interest rate lowers). Thus, when entrepreneurs observe a low interest rate, they should recognize that 1) consumers are saving for future consumption, and 2) this is the most opportune time to start a business, as the cost of borrowing capital is low. 

Upon recognizing the real function of the interest rate, it becomes more clear that any exogenous influence on the interest rate (Federal Reserve policy esp.) degrades the quality of the interest rate as an indicator to entrepreneurs. It should be recognized that the level of manipulation of the interest rate has a direct relationship to the quality of information entrepreneurs possess to help them fulfill their function.

So, what are the implications of entrepreneurs having inaccurate information? According to Hayek and many others, malinvestment. Currently, the Fed's policy has the interest rate target at 0-.25% - which is a very low level that should be indicative of a very high level of savings. But this is not the case: personal savings rates are really near an all time low ( 

As entrepreneurs see these low interest rates, they may assume that the economy is healthy, people have lots of money saved, and they are ready  to consume some new products. In seeing this, they may decide to open a new business to capitalize on the perceived health of the economy. However, what they will find is that personal savings are basically non-existent, and consumers are not ready to spend any money, hence, malinvestment, which leads to further economic disease. 

In conclusion, the interest rate (and unemployment and price levels) should be recognized as spontaneous phenomenon that are the result of, and an indication of, economic conditions. If the interest rate is seen to be a cause of economic health, rather than its result, policy makers will try to 'fix' the interest rate at levels that they have observed coinciding with economic health. As we have observed already, tampering with these emergent signals will lead to the further degradation of the economy and prosperity in general.  

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